Austerity does not necessarily require a cut in government spending

The Bloomberg Op Ed article (August 19, 2014) – European Austerity Is a Myth – is about as flaky as it gets. The author is intent on justifying the article title by examining changes in government spending (as a per cent of GDP). He produces what he claims is “more appropriately called the ‘graph of the decade’”, which would mean it was some graph, but in reality tells us very little and does not provide the basis for his conclusion that rising government spending since 2007 is evidence that austerity has not been imposed. Oh dear! Some points need to be made. The so-called – graph of the decade – was produced by Eurostat and appeared in the European Commission paper – Public Spending Reviews: design, conduct, implementation – produced by the Ecofin Committee.

You can also read a – Summary for non-specialists.

The graph shows the levels of government spending as a per cent of GDP for European nations in 2007 and 2013, and surprise surprise, the 2013 levels are higher in all but four nations (Bulgaria, Lithuania, Poland, and Romania). The Ecofin commentary says that:

The picture varies across the EU, reflecting national preferences and political decisions. In six Member States, public spending accounts for more than 54% of GDP, while in another six, the proportion is between 34% and 39%.

In the EU as a whole, the public expenditure-to-GDP ratio increased by 3.5 percentage points between 2007, the year preceding the crisis, and 2013. Four Member States, however, have managed to stabilize or even reduce their expenditure-to-GDP ratios over that period.

I produced the following version of the graph which just shows the change in nominal public spending as a proportion of GDP between 2007 and 2013 using the Eurostat data.

Okay, the evidence is clear. Government spending as a proportion of GDP in most nations rose during the crisis. The Bloomberg author claims that the total public spending in the EU initally rose (he uses the emotive word “ballooned”) and then “shrank a little”.

The conclusion about the shrinkage:

That, however, was not the result of government’s austerity efforts: Rather, the spending didn’t go down as much as the economies collapsed, and then didn’t grow in line with the modest rebound. In Italy, for example, the government spent 47.6 percent of GDP in 2007 and 50.6 percent of GDP in 2013, when economic output was 2.6 percent lower than in 2007. The country’s economy dipped into recessions, surfaced, struggled — but the government spent more or less as much money as before.

So he is just pointing out the obvious that the measure the graph focuses on is a ratio with spending as the numerator and GDP as the denominator. A ratio can move as a result of both components changing and so without firm knowledge of the components it is difficult to make unambiguous interpretations.

Given the collapse of GDP in many countries, the ratio will rise. For example, total public spending in Greece rose by 0.5 million euros between 2007 and 2013 (and fell substantially in real terms) but the nominal GDP fell by around 18.5 per cent over the same period, which accounts for the rise in the ratio.

Would anyone not conclude that Greece had undergone a dramatic austerity program even though government spending did not fall?

The point the Bloomberg author really wants to make is that public spending is in his view wasteful. He cites an example he copied from the Economist magazine:

The ushers at the Italian Parliament, whose job is to carry messages in their imposing gold-braided uniforms, made $181,590 a year by the time they retired, but will only make as much as $140,000 after Renzi’s courageous cut. If you wonder what on earth could be wrong with getting rid of them altogether and just using e-mail, you just don’t get European public expenditure. It’s about preserving old inefficiencies as venerable traditions.

Its also about buttressing total spending. Using E-mail will probably save outlays, but what will happen to the economy as that spending and the multiplied effects once the worker spends his/her wages are lost? What will take its place?

Will Italian firms invest more to make up the difference when total spending and sales are in decline, just because the Italian Parliament is more “efficient”?

That is the macroeconomics issue that this author ignores.

He cites cases on senior Italian government officials earning “12 times the national average salary” as evidence there is “plenty of room for cuts in European bureaucracies”. I note he doesn’t mention the pay of private management elites relative to average wages.

I don’t seek to justify the wages of the senior managers. But apart from equity issues, the macroeconomic question is still relevant. If you cut that spending source what will replace it?

On the equity issue, it might be justified in hacking into executive pay. After all, the neo-liberal era has accelerated income inequality and driven a massive gap between the earnings of the lower and middle income earners and the top-end-of-town.

The largesse, by the way, came from the massive redistribution of national income towards profits as real wages growth lagged behind productivity growth.

But the problem is not confined to the public sector and cannot be used to argue that the public sector has a monopoly on waste.

In 2013 in Australia, for example, it was reported that the “bosses of Australia’s leading companies” were “taking home almost 70 times the national average salary” and the “10-year trend, however, is much more stark, with executive fixed pay increasing almost three times as fast as inflation since 2002, and nearly 70 per cent faster than average wages growth”.

So perhaps we attack all executive salaries – public and private. The loss of total spending would be smaller than if we attacked the salaries of lower income workers because the higher income groups save more per dollar/euro.

But if total spending is inadequate (to achieve full employment) then something has to replace the specific, targetted cuts that are made.

The Bloomberg authors gets to his point with this conclusion:

There is no rational justification for European governments to insist on higher spending levels than in 2007. The post-crisis years have shown that in Italy, and in the EU was a whole, increased reliance on government spending drives up sovereign debt but doesn’t result in commensurate growth. The idea of a fiscal multiplier of more than one — every euro spent by the government coming back as a euro plus change in growth — obviously has not worked.

And then goes into a rave about “increased government interference in the economy” and that governments spending is not helping the recovery.

Who gave this guy a job?

First, the fact that government spending as a proportion of GDP has risen but economic growth still lags is not evidence that the spending multiplier has failed. The point this author ignores is that other things are not equal.

The true test of whether the expenditure multiplier is less than or greater than one is to examine what happens to economic growth (real GDP) if government spending rises while all other expenditure (non-government) is constant.

The point he ignores is that all spending – government or non-government – multiplies through the expenditure stream to create final growth outcomes.

If we assume for simplicity that the multiplier is similar for government and non-government spending and non-government spending is falling by more than government spending is rising, then we would expect to see overall output growth declining even though every dollar of government spending might be generating, say, 1.5 times the change in total spending.

Its just that the greater decline in non-government spending is also multiplying to a decline in total spending. The net result – decline.

Second, even if government spending is increasing in absolute terms, relative to GDP, or relative to its revenue, we cannot conclude that the fiscal stance of the government is not one of austerity.

Austerity doesn’t necessarily mean that government spending is declining. It has to be seen in context of what the other components of spending are doing and what is required in that context to keep growth growing at, say, its previous trend.

The fiscal deficit might be rising but we would still conclude that there is austerity if the net decrease in private spending, for example, has not been more than offset by the rising in the deficit.

Austerity is about the functional role of fiscal policy and merely focusing on government spending.

The following graph shows what happened to private gross capital formation (investment) between 2007 and 2013. What would the author conclude about that?

If government spending had not risen, given the collapse in private investment, what do you suppose might have happened to overall growth?

Further, when you examine the total expenditure mix (consumption, government, private investment and net exports), very few nations experienced a rise in total expenditure as a proportion of GDP between 2007 and 2013.

Conclusion

Given unemployment rose dramatically in most nations, the obvious conclusion is that the rise in government spending was insufficient and thus the policy makers have deliberately imposed austerity on their nations.

This article is just another in a long line of denials and is more overt than others that at least understand how to use the statistical concepts more reasonably.

That is enough for today!

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.